It seems like it’s unfashionable these days for investors to worry about startup valuations. In my opinion, that kind of thinking is likely to lead to disaster for both investors and startups.

Far too many people make the mistake of focusing on relative valuation. “This deal is a bargain in comparison to the other deals I see.” The right approach is to calculate a valuation based on fundamental principles. Much like Warren Buffet, the intelligent investor focuses on how much a company is actually worth, not how much others are willing to pay.

To that end, I thought I’d share my simple heuristic for calculating a reasonable startup valuation:

Reasonable Valuation = (1/2 * Exit Value) / 3

Each of the terms has its purpose.

The 1/2 is to account for dilution. Let’s say a startup raises two VC rounds before an exit. If the VCs take 30% of the company in each round, the original equity is sliced neatly in half (0.7 * 0.7 = 0.49). You could even argue that 1/2 is too aggressive, and that it should really be 1/3.

Dividing by 3 is to account for the classic 3X cash-on-cash return benchmark. Because angel and venture investments are risky and illiquid, they need to earn outstanding returns to justify the risk incurred. The classic benchmark is being able to triple your money over the life of a fund, which is typically 7-10 years. Again, this is aggressive; you’d need an even higher divisor to match a top quartile return.

But let’s just treat those two terms as constants for now. 1/2 and 3 are good enough for estimation purposes, given the uncertainty associated with any startup.

The implication is that Reasonable Valuation (RV) is a function of Average Exit Value (AEV).

For example, if you think that the AEV is $20 million (and this is the average across all investments, successful and otherwise), then the RV = (1/2 * $20) / 3 = $3.3 million.

When valuations creep up to the $10 million range, the implication is that the *average* exit needs to be $60 million. If you buy that, I’ve got a bridge I want to sell you.

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VP Enterprise Marketing for PBworks, first investor in and previously interim CEO of Ustream.TV. Chris is an active angel investor and the founder and Chairman of the Harvard Business School Technology Alumni Association (HBSTECH). Chris earned two degrees from Stanford University and an MBA from Harvard Business School. His personal blogs are Adventures in Capitalism and Ask the Harvard MBA.